Inside the Financial Market Mindset

How emotions and other psychological factors drive it

By: Alexandria Chun, Staff Writer

Image courtesy of Tal Gertin

Financial markets are traditionally thought to be arenas of rational decision-making in which players make calculated investments based on facts and figures. The catch: market players are human. Behind the charts and share prices are people vulnerable to bias and emotion. This is why markets can’t be deemed fully rational institutions. But that’s not to say they’re irrational. Emotions don’t always cause irrationality. In fact, emotions can play a valuable role in successful decision-making.

What roles do emotions play in financial decision-making? Emotions are subconscious responses to events that provide a “summary” of experience. This summary isn’t a synopsis, per se, but rather a feeling that encompasses a person’s impression of the situation at hand. This feeling is also known as intuition.

[pullquote]Humans are naturally loss averse. Be it objects, people, or reputation, losing things generally makes people unhappy.[/pullquote]

A study conducted by London-based psychologists described this rapid decision-making mechanism as “pattern recognition [that] activates emotionally weighted biases which in turn activate stored behavioral repertoires.” In other words, certain situations make us feel and act in certain ways. Contrary to the notion of a rational investor, emotions can be used to facilitate financial decision-making. However, it takes a certain amount of experience to realize which instincts are well-founded, and which are not.

Emotions also play an important role in the social aspect of trading; that is, how the choices of others influence your own. An old saying on Wall Street goes: “It is always warmest inside the herd,” meaning there is security in numbers. For example, in the recent LIBOR scandal, Barclays later reported that it “was under-reporting its rate to avoid the stigma associated with being an outlier with respect to its LIBOR submissions, relative to other participating banks.” Clearly, this wasn’t an entirely rational decision because there were potentially harmful consequences that should have outweighed social pressures. But this concept of not being an “outlier” is one that drives many decisions. On paper, the choice may not be the most appropriate, but if a majority of the group is participating, it’s emotionally difficult to stray from the herd.

On a similar note, if there is a sudden rush to invest in a newly discovered company, it must be promising, right?

Wrong.

It’s true that watching others flock toward an investment opportunity evokes curiosity and even envy. But the latter is a particularly dangerous emotion, as it is spurred by competition and fear of loss. Humans are naturally loss averse. Be it objects, people, or reputation, losing things generally makes people unhappy. Therefore, the possibility of missing out causes some investors to make rash decisions.